Tax reform with endogenous borrowing limits and incomplete asset markets

Abstract

This paper studies different income tax reforms in an infinite horizon economy with a progressive labor income tax code, incomplete markets and endogenous borrowing constraints on asset holdings. The endogenous limits are determined at the level at which households are indifferent between defaulting and paying back their un-secured debt. The reforms we study area all revenue neutral and they eliminate capital income taxes but they differ in the changes to the labor income tax code. Our results illustrate that a successful reform has to combine the elimination of capital income taxes with an increase in the progressivity of the labor income tax code. On the one hand, this reduces the disposable income of the rich, leading to lower savings and to a lower aggregate capital. On the other hand, it allows the middle income households to save more at a higher after tax interest rate and the low income households to borrow more on a lower interest rate. This increases welfare both in the long run and throughout the transition. The welfare gains are hence obtained not through more capital accumulation but by reducing wealth and consequently consumption inequality.